FFM 9 Im 13

SOLUTIONS TO END-OF-CHAPTER PROBLEMS
Chapter13
13-1
a. Project A:
0 10%
|
-10,000
1
|
6,000
2
|
8,000
Using a financial calculator, input the following data:

CF0 =
-10000, CF1 = 6000, CF2 = 8000, I = 10, and then solve for NPV A =
$2,066.12.
Project B:
0 10%
|
-10,000
1
|
4,000
2
|
4,000
3
|
4,000
4
|
4,000

CF0 =
-10000, CF1-4 = 4000, I = 10, and the solve for NPVB = $2,679.46.
Since neither project can be repeated, Project B should be selected
because it has a higher NPV than Project A.
b. To determine the answer to part b, we must use the replacement chain
(common life) approach to calculate the extended NPV for Project A.
Project B already extends out to 4 years, so its NPV is $2,679.46.
Project A:
0 k = 10%
|
-10,000
1
|
6,000
2
|
8,000
-10,000
-2,000
3
|
6,000
4
|
8,000

CF0 =
-10000, CF1 = 6000, CF2 = -2000, CF3 = 6000, CF4 = 8000, I = 10, and
then solve for NPVA = $3,773.65.
Since Project As extended NPV = $3,773.65, it should be selected over
Project B with an NPV = $2,679.46.
13-2
WACC1 = 12%; WACC2 = 12.5%.

Since each project is independent and of average risk, all projects whose
IRR > WACC will be accepted. Consequently, Projects A, B, C, D, and E
will be accepted and the optimal capital budget is $5,250,000.
Harcourt, Inc. items and derived items copyright 2000 by Harcourt, Inc.
Answers and Solutions: 13 - 1
13-3
Since Projects C and D are now mutually exclusive only one of them can be
accepted.
The project with the higher NPV should now be chosen.
Therefore, Project D should be selected over Project C. The projects now
selected are A, B, D, and E with an optimal capital budget of
$4 million.
13-4
Projects
A
B
C
D
E
F
G
Risk
High
Average
Average
Average
Average
Low
Low
Risk-adjusted
WACC
14.5%
12.5
12.5
12.5
12.5
10.5
10.5
IRR
14.0%
13.5
13.2
13.0
12.7
12.3
12.2
Decision
Reject
Accept
Accept
Accept
Accept
Accept
Accept
On the basis of a risk-adjusted WACC, Projects B, C, D, E, F, and G will

be accepted an only Project A will be rejected.
The firms optimal
capital budget is $6 million.
13-5
NPV190-3 = $11,982 (for 3 years).

Extended NPV190-3 = $11,982 + $11,982/(1.14)3 = $20,070.
NPV360-6 = $22,256 (for 6 years).
Both new machines have positive NPVs; hence the old machine should be
replaced. Further, since its NPV is greater, choose Model 360-6.
13-6
Plane A: Expected life = 5 years; Cost = $100 million; NCF = $30 million;
COC = 12%.
Plane B: Expected life = 10 years; Cost = $132 million; NCF = $25
million; COC = 12%.
A:
012% 1
|
|
-100
30
2
|
30
3
|
30
4
|
30
5
|
30
6
|
30
-100
-70
7
|
30
8
|
30
9
|
30
10
|
30
Enter these values into the cash flow register: CF 0 = -100; CF1-4 = 30;
CF5 =
-70;
CF6-10 = 30. Then enter I = 12, and press the NPV key to get NPV A = 12.764
$12.76 million.
B:
012% 1
|
|
-132
25
2
|
25
3
|
25
4
|
25
5
|
25
6
|
25
7
|
25
8
|
25
9
|
25
10
|
25
Enter these cash flows into the cash flow register, along with the
interest
rate,
and press the NPV key to get NPVB = 9.256 $9.26 million.
Project A is the better project and will increase the company's value
by $12.76 million.
13-7
A:
010%
|
-10
1
|
4
2
|
4
3
|
4
4
|
4
-10
-6
5
|
4
6
|
4
7
|
4
8
|
4
Machine As simple NPV is calculated as follows: Enter CF 0 = -10 and

CF1-4
= 4.
Then enter
I = 10, and press the NPV key to get NPV A = $2.679 million.
However,
this does not consider the fact that the project can be repeated again.
Enter these values into the cash flow register: CF 0 = -10; CF1-3 = 4; CF4
= -6; CF5-8 = 4. Then enter I = 10, and press the NPV key to get Extended
NPVA = $4.5096 $4.51 million.
B:
010% 1
|
|
-15
3.5
2
|
3.5
3
|
3.5
4
|
3.5
5
|
3.5
6
|
3.5
7
|
3.5
8
|
3.5
Enter these cash flows into the cash

flow register, along with the interest rate, and press the NPV key to get
NPVB = $3.672 $3.67 million.
Machine A is the better project and will increase the company's value
by $4.51 million.
13-8
a.
012%
|
-20
1
|
3
2
|
3
20
|
3
NPV = $2.4083 million.

b. Wait 1 year:
Tax imposed
25% Prob.
k0 = 12% 1
|
|
0
-20
2
|
2.4
3
|
2.4
Tax not imposed

75% Prob.
|
0
|
3.2
|
3.2
|
-20
3.2
NPV @
21
Yr. 0
|
2.4 -$1.8512
|
3.2
3.4841
Note though, that if the tax is imposed, the NPV of the project is
negative and therefore would not be undertaken.
The value of this
option of waiting one year is evaluated as 0.25($0) + (0.75)($3.4841)
= $2.6131 million.
Since the NPV of waiting one year is greater than going ahead and
proceeding with the project today, it makes sense to wait.
13-9
a. NPV of abandonment after Year t:

Using a financial calculator, input the following:
CF 0 = -22500,
CF1 = 23750, and I = 10 to solve for NPV1 = -$909.09 -$909.
CF 0 = -22500,
CF1 = 6250, CF2 = 20250, and I = 10 to solve for NPV2 = -$82.64 -$83.
CF 0 = -22500,
CF1 = 6250, Nj = 2, CF3 = 17250, and I = 10 to solve for NPV 3 =
$1,307.29 $1,307.
CF 0 = -22500,
CF1 = 6250, Nj = 3, CF4 = 11250, and I = 10 to solve for
NPV 4 =
$726.73 $727.
CF 0 = -22500,
CF1 = 6250, Nj = 5, and I = 10 to solve for NPV5 = $1,192.42 $1,192.
The firm should operate the truck for 3 years, NPV3 = $1,307.
b. No.
Abandonment possibilities could only raise NPV and IRR.
The
value of the firm is maximized by abandoning the project after Year 3.
13-10 a.
010%
-8
NPV = $4.6795 million.

b. Wait 2 years:
0 = 10% 1
k
|
|
10% Prob. 0
0
2
|
-9
3
|
2.2
4
|
2.2
5
|
2.2
NPV @
6
Yr. 0
|
2.2 -$1.6746
|
90% Prob. 0
|
-9
|
4.2
|
4.2
|
4.2
|
4.2
|
0
3.5648
If the cash flows are only $2.2 million, the NPV of the project is
negative and, thus, would not be undertaken. The value of the option
of waiting two years is evaluated as 0.10($0) + 0.90($3.5648) =
$3.2083 million.
Since the NPV of waiting two years is less than going ahead and
proceeding with the project today, it makes sense to drill today.
13-11 a.
013%
|
-300
1
|
40
2
|
40
NPV = -$19.0099 million.
20
|
40
Dont purchase.
b. Wait 1 year:
k0 = 13% 1
|
|
50% Prob. 0
-300
2
|
30
3
|
30
4
|
30
|
50% Prob. 0
|
50
|
50
|
50
|
-300
NPV @
Yr. 0
21
|
30
-$78.9889
|
50
45.3430
If the cash flows are only $30 million per year, the NPV of the
project is negative. However, weve not considered the fact that the
company could then be sold for $280 million. The decision tree would
then look like this:
0 = 13% 1
k
|
|
50% Prob. 0
-300
2
|
30
3
|
30 + 280
4
|
0
|
50% Prob. 0
|
50
|
50
|
50
|
-300
NPV @
Yr. 0
21
|
0
-$27.1468
|
50
45.3430
The expected NPV of waiting 1 year is 0.5(-$27.1468) + 0.5($45.3430) =

$9.0981 million.
Given the option to sell, it makes sense to wait 1 year before
deciding whether to make the acquisition.
13-12 a.
0 12%
|
-6,200,000
1
|
600,000
14
|
600,000
15
|
600,000
Using
a
financial
calculator,
input
the
following
data:
CF0 = -6,200,000; CF1-15 = 600,000; I = 12; and then solve for NPV =
-$2,113,481.31.
b.
0 12%
|
-6,200,000
1
|
1,200,000
14
|
1,200,000
15
|
1,200,000
Using
a
financial
calculator,
input
the
following
data:
CF0 = -6,200,000; CF1-15 = 1,200,000; I = 12; and then solve for NPV =
$1,973,037.39.
c. If they proceed with the project today, the projects expected NPV =
(0.5 -$2,113,481.31) + (0.5 $1,973,037.39) = -$70,221.96.
So,
Nevada Enterprises would not do it.
d. Since the projects NPV with the tax is negative, if the tax were
imposed the firm would abandon the project. Thus, the decision tree
looks like this:
0k = 12%
1
50% Prob.
|
|
Taxes
-6,200,000
6,000,000
No Taxes
|
50% Prob. -6,200,000
|
1,200,000
2
|
0
|
1,200,000
15
|
0
NPV @
Yr. 0
-$
842,857.14
|
1,200,000
1,973,037.39
Expected NPV $ 565,090.13
Yes, the existence of the abandonment option changes the expected NPV
of the project from negative to positive. Given this option the firm
would take on the project because its expected NPV is $565,090.13.
e.
50% Prob.
Taxes
0k = 12%
1
|
|
NPV = ?
-1,500,000
wouldnt do
+300,000 = NPV @ t = 1
No Taxes
50% Prob.
|
NPV = ?
|
-1,500,000
+4,000,000 = NPV @ t = 1
NPV @
Yr. 0
$
0.00
2,232,142.86
Expected NPV $1,116,071.43
If the firm pays $1,116,071.43 for the option to purchase the land,
then the NPV of the project is exactly equal to zero.
So the firm
would not pay any more than this for the option.
SPREADSHEET
CYBERPROBLEM
PROBLEM
13-13 The detailed solution for the spreadsheet problem is available on the
instructors resource CD-ROM and on the instructors side of the Harcourt
College Publishers web site, http://www.harcourtcollege.com/finance/
brigham.
13-14 The detailed solution for the cyberproblem is available on the

instructors side of the Harcourt College Publishers web site,
http://www.harcourtcollege.com/finance/brigham.
Computer/Internet Applications: 13 - 8
Harcourt, Inc.
Harcourt, Inc. items and derived items copyright 2000 by
INTEGRATED CASE
21st Century Educational Products

Other Topics in Capital Budgeting
13-15
21ST CENTURY EDUCATIONAL PRODUCTS (21ST CENTURY) IS A RAPIDLY GROWING

SOFTWARE COMPANY, AND CONSISTENT WITH ITS GROWTH, IT HAS A RELATIVELY
LARGE CAPITAL BUDGET.
WHILE MOST OF THE COMPANYS PROJECTS ARE
FAIRLY EASY TO EVALUATE, A HANDFUL OF PROJECTS INVOLVE MORE COMPLEX

EVALUATIONS.
JOHN KELLER, A SENIOR MEMBER OF THE COMPANYS FINANCE STAFF,
COORDINATES THE EVALUATION OF THESE MORE COMPLEX PROJECTS.
HIS GROUP
BRINGS THEIR RECOMMENDATIONS DIRECTLY TO THE COMPANYS CFO AND CEO,

KRISTIN RILEY AND BOB STEVENS, RESPECTIVELY.
A.
RIGHT NOW, KELLERS GROUP IS LOOKING AT A VARIETY OF INTERESTING

PROJECTS.
FOR EXAMPLE, THE GROUP HAS BEEN ASKED TO CHOOSE BETWEEN
THE FOLLOWING TWO MUTUALLY EXCLUSIVE PROJECTS:

EXPECTED NET CASH FLOWS
PROJECT S
PROJECT L
($100,000)
($100,000)
59,000
33,500
59,000
33,500
-33,500
-33,500
YEAR
0
1
2
3
4
BOTH PROJECTS MAY BE REPEATED AND BOTH ARE OF AVERAGE RISK, SO THEY
SHOULD BE EVALUATED AT THE FIRM'S COST OF CAPITAL, 10 PERCENT.
WHICH ONE SHOULD BE CHOSEN?
ANSWER:
[SHOW S13-1 THROUGH S13-5 HERE.]

PROJECT S:
0 10%
|
-100,000
1
|
59,000
2
|
59,000
-100,000
-41,000
3
|
59,000
4
|
59,000
Integrated Case: 13 - 9
USING A FINANCIAL CALCULATOR, INPUT THE FOLLOWING DATA:
CF0 =
-100,000; CF1 = 59,000; CF2 = -41,000; CF3-4 = 59,000; I = 10; AND THEN
SOLVE FOR NPV = $4,377.43.
PROJECT L:
0 10%
|
-100,000
1
|
33,500
2
|
33,500
3
|
33,500
4
|
33,500
CF0 =
-100,000; CF1-4 = 33,500; I = 10; AND THEN SOLVE FOR NPV = $6,190.49.
PROJECT L SHOULD BE CHOSEN SINCE IT HAS A HIGHER NPV THAN PROJECT S.
B.
IN RECENT MONTHS, KELLERS GROUP HAS BEGUN TO FOCUS ON REAL OPTION

ANALYSIS.
1. WHAT IS REAL OPTION ANALYSIS?
ANSWER:
[SHOW S13-6 HERE.]
REAL OPTIONS EXIST WHEN MANAGERS CAN INFLUENCE
THE SIZE AND RISKINESS OF A PROJECTS CASH FLOWS BY TAKING DIFFERENT

ACTIONS DURING OR AT THE END OF A PROJECTS LIFE.
REAL OPTION ANALYSIS INCLUDES IN THE TYPICAL NPV CAPITAL BUDGETING
ANALYSIS AN ANALYSIS FOR OPPORTUNITIES FOR MANAGERS TO RESPOND TO
CHANGING CIRCUMSTANCES BECAUSE MANAGEMENTS ACTIONS CAN INFLUENCE A
PROJECTS OUTCOME.
B.
2. WHAT ARE SOME EXAMPLES OF PROJECTS WITH EMBEDDED REAL OPTIONS?
ANSWER:
[SHOW S13-7 HERE.]
A PROJECT MAY CONTAIN ONE OR MORE DIFFERENT TYPES
OF EMBEDDED REAL OPTIONS.
EXAMPLES INCLUDE ABANDON-MENT/SHUTDOWN
OPTIONS, INVESTMENT TIMING OPTIONS, GROWTH/EXPANSION OPTIONS, AND

FLEXIBILITY OPTIONS.
C.
TAKING REAL OPTIONS INTO ACCOUNT, ONE OF KELLERS COLLEAGUES, BARBARA

HUDSON, HAS SUGGESTED THAT INSTEAD OF INVESTING IN PROJECT L TODAY,
IT MIGHT MAKE SENSE TO WAIT A YEAR BECAUSE 21ST CENTURY WOULD LEARN A
LOT MORE ABOUT MARKET CONDITIONS AND WOULD BE BETTER ABLE TO FORECAST
THE PROJECT'S CASH FLOWS.
RIGHT NOW, 21ST CENTURY FORECASTS THAT
PROJECT L WILL GENERATE EXPECTED YEARLY NET CASH FLOWS OF $33,500.

HOWEVER, IF THE COMPANY WAITS A YEAR, IT WILL LEARN MORE ABOUT MARKET
CONDITIONS.
THERE IS A 50 PERCENT CHANCE THAT THE MARKET WILL BE
STRONG AND A 50 PERCENT CHANCE IT WILL BE WEAK.
IF THE MARKET IS
STRONG, THE YEARLY CASH FLOWS WILL BE $43,500.
IF THE MARKET IS
WEAK, THE YEARLY CASH FLOWS WILL BE ONLY $23,500.
IF 21ST CENTURY
CHOOSES TO WAIT A YEAR, THE INITIAL INVESTMENT WILL REMAIN $100,000.

ASSUME THAT ALL CASH FLOWS ARE DISCOUNTED AT 10 PERCENT.
SHOULD 21ST
CENTURY INVEST IN PROJECT L TODAY, OR SHOULD IT WAIT A YEAR BEFORE

DECIDING WHETHER TO INVEST IN THE PROJECT?
ANSWER:

50% PROB.
0
k = 10% 1
STRONG MKT. |
|
0
-100,000
2
|
43,500
3
|
43,500
4
|
43,500
5
|
43,500
NPV
@ t = 1
$37,889.15
WEAK MKT.
50% PROB.
|
23,500
|
23,500
|
23,500
|
23,500
-25,508.16
|
0
|
-100,000
HOWEVER, IN A WEAK MARKET THE FIRM WILL NOT UNDERTAKE PROJECT L SINCE
ITS NPV < 0.
CONSEQUENTLY, THE EXPECTED NPV OF WAITING ONE YEAR IS
(0.5)$0 + (0.5)($37,889.15) = $18,944.58.
HOWEVER, THIS IS THE
PRESENT VALUE AT YEAR 1, SO MUST DISCOUNT IT BACK ONE YEAR TO FIND

THE VALUE TODAY OF WAITING TO DO PROJECT L.
SO, THE VALUE TODAY OF
WAITING IS CALCULATED AS $18,944.58/1.10 = $17,222.34. THEREFORE, THE

FIRM SHOULD WAIT TO GET MORE INFORMATION ABOUT THE MARKET RATHER THAN
UNDERTAKING PROJECT L TODAY BECAUSE THE NPV IS $17,222.34 COMPARED TO
$6,190.49, THE NPV OF DOING IT TODAY.
D.
NOW LETS ASSUME THAT THERE IS MORE UNCERTAINTY ABOUT THE FUTURE CASH
FLOWS.
MORE SPECIFICALLY, ASSUME THAT THE YEARLY CASH FLOWS ARE NOW
$53,500 IF THE MARKET IS STRONG AND $13,500 IF THE MARKET IS WEAK.

ASSUME THAT THE UP-FRONT COST IS STILL $100,000 AND THAT THE COST OF
CAPITAL IS STILL 10 PERCENT.
WILL THIS INCREASED UNCERTAINTY MAKE
THE FIRM MORE OR LESS WILLING TO INVEST IN THE PROJECT TODAY?
ANSWER:
[SHOW S13-12 AND S13-13 HERE.]

50% PROB.
0k = 10% 1
STRONG MKT. |
|
0
-100,000
2
|
53,500
3
|
53,500
4
|
53,500
5
|
53,500
NPV
@ t = 1
$69,587.80
WEAK MKT.
50% PROB.
|
13,500
|
13,500
|
13,500
|
13,500
-57,206.82
|
0
|
-100,000
IN A WEAK MARKET THE FIRM WILL NOT UNDERTAKE PROJECT L SINCE ITS NPV
< 0.
CONSEQUENTLY, THE EXPECTED NPV OF WAITING ONE YEAR IS (0.5)$0 +
(0.5)($69,587.80) = $34,793.90.
HOWEVER, THIS IS THE PRESENT VALUE
AT YEAR 1, SO WE MUST DISCOUNT IT BACK ONE YEAR TO FIND THE VALUE

TODAY OF WAITING TO DO PROJECT L.
SO, THE VALUE TODAY OF WAITING IS
CALCULATED AS $34,793.90/1.10 = $31,630.82.
THEREFORE, THE FIRM
SHOULD WAIT TO GET MORE INFORMATION ABOUT THE MARKET RATHER THAN
UNDERTAKING PROJECT L TODAY BECAUSE THE NPV IS $31,630.82 COMPARED TO
$6,190.49, THE NPV OF DOING IT TODAY.
THE MORE VARIABLE THE CASH FLOWS (THE MORE UNCERTAINTY) THE LESS
WILLING THE FIRM WILL BE TO INVEST IN THE PROJECT TODAY.
FACTORS THE FIRM SHOULD CONSIDER WHEN DECIDING WHEN TO INVEST:
1. DELAYING THE PROJECT MEANS THAT CASH FLOWS COME LATER RATHER THAN
SOONER.
2. IT
MIGHT
MAKE
SENSE
TO
PROCEED
TODAY
IF
THERE
ARE
IMPORTANT
ADVANTAGES TO BEING THE FIRST COMPETITOR TO ENTER A MARKET.

3. WAITING MAY ALLOW YOU TO TAKE ADVANTAGE OF CHANGING CONDITIONS.
E.
21ST CENTURY IS CONSIDERING ANOTHER PROJECT, PROJECT Y.
PROJECT Y
HAS AN UP-FRONT COST OF $200,000 AND AN ECONOMIC LIFE OF THREE YEARS.

IF THE COMPANY DEVELOPS THE PROJECT, ITS AFTER-TAX OPERATING COSTS
WILL BE $100,000 A YEAR; HOWEVER, THE PROJECT IS EXPECTED TO PRODUCE
AFTER-TAX CASH INFLOWS OF $180,000 A YEAR.
THUS, THE PROJECTS
ESTIMATED CASH FLOWS ARE AS FOLLOWS:

YEAR
0
1
2
3
CASH OUTFLOWS
-$200,000
-100,000
-100,000
-100,000
CASH INFLOWS
$
0
180,000
180,000
180,000
NET CASH FLOWS

-$200,000
80,000
80,000
80,000
1. THE PROJECT HAS AN ESTIMATED COST OF CAPITAL OF 10 PERCENT.
WHAT IS
THE PROJECTS NPV?

ANSWER:
[SHOW S13-14 HERE.]

0 10%
|
-200,000
1
|
80,000
2
|
80,000
3
|
80,000
CF0 =
-200,000; CF1-3 = 80,000; I = 10; AND THEN SOLVE FOR NPV = -$1,051.84.
E.
2. WHILE THE PROJECTS OPERATING COSTS ARE FAIRLY CERTAIN AT $100,000

PER YEAR, THE ESTIMATED CASH INFLOWS DEPEND CRITICALLY ON WHETHER
21ST CENTURY'S LARGEST CUSTOMER USES THE PRODUCT.
KELLER ESTIMATES
THAT THERE IS A 60 PERCENT CHANCE THE CUSTOMER WILL USE THE PRODUCT,
IN WHICH CASE THE PROJECT WILL PRODUCE AFTER-TAX CASH INFLOWS OF
$250,000.
THUS, ITS NET CASH FLOWS WOULD BE $150,000 PER YEAR.
HOWEVER, THERE IS A 40 PERCENT CHANCE THE CUSTOMER WILL NOT USE THE
PRODUCT,
INFLOWS
IN
WHICH
OF
-$25,000.
ONLY
CASE
THE
$75,000.
PROJECT
THUS,
WILL
ITS
NET
PRODUCE
CASH
AFTER-TAX
FLOWS
WOULD
CASH
BE
WRITE OUT THE ESTIMATED CASH FLOWS, AND CALCULATE THE
PROJECTS NPV UNDER EACH OF THE TWO SCENARIOS.

ANSWER:

CUSTOMER USES PRODUCT (60% PROBABILITY)
0 10%
|
-200,000
1
|
150,000
2
|
150,000
3
|
150,000

-200,000;
CF1-3
150,000;
10;
AND
THEN
SOLVE
FOR
CF0 =
NPV
$173,027.80.
CUSTOMER DOESNT USE PRODUCT (40% PROBABILITY)
0 10%
|
-200,000
1
|
-25,000
2
|
-25,000
3
|
-25,000

-200,000;
CF1-3
-25,000;
10;
AND
THEN
SOLVE
FOR
CF0 =
NPV
-$262,171.30.
E.
3. WHILE 21ST CENTURY DOES NOT HAVE THE OPTION TO DELAY THE PROJECT, IT
WILL KNOW ONE YEAR FROM NOW IF THE KEY CUSTOMER HAS SELECTED THE
PRODUCT.
IF THE CUSTOMER CHOOSES NOT TO ADOPT THE PRODUCT, 21ST
CENTURY HAS THE OPTION TO ABANDON THE PROJECT.
IF IT ABANDONS THE
PROJECT, IT WILL NOT RECEIVE ANY CASH FLOWS AFTER YEAR 1, AND IT WILL
NOT INCUR ANY OPERATING COSTS AFTER YEAR 1.
THUS, IF THE COMPANY
CHOOSES TO ABANDON THE PROJECT, ITS ESTIMATED CASH FLOWS ARE AS

FOLLOWS:
60% PROB.
0
|
-200,000
1
|
150,000
40% PROB.
|
-200,000
|
-25,000
AGAIN,
ASSUMING
COST
OF
2
|
150,000
CAPITAL
OF
10
3
|
150,000
PERCENT,
WHAT
PROJECTS EXPECTED NPV IF IT ABANDONS THE PROJECT?
IS
THE
SHOULD 21ST
CENTURY INVEST IN PROJECT Y TODAY, REALIZING IT HAS THE OPTION TO

ABANDON THE PROJECT AT t = 1?
ANSWER:

0k = 10%
1
|
|
60% PROB. -200,000
150,000
|
40% PROB. -200,000
2
|
150,000
3
|
150,000
|
-25,000
NPV @ t = 0
$173,027.80
-222,727.27
E(NPV) = 0.6($173,027.80) + 0.4(-$222,727.27)

= $14,725.77.
E.
4. UP UNTIL NOW WE HAVE ASSUMED THAT THE ABANDONMENT OPTION HAS NOT
AFFECTED
THE
REASONABLE?
PROJECTS
COST
OF
CAPITAL.
IS
THIS
ASSUMPTION
HOW MIGHT THE ABANDONMENT OPTION AFFECT THE COST OF
CAPITAL?
ANSWER:
[SHOW
S13-19
HERE.]
IT
IS
NOT
REASONABLE
TO
ASSUME
ABANDONMENT OPTION HAS NO EFFECT ON THE COST OF CAPITAL.
THAT
THE
HAVING THE
ABILITY TO ABANDON A PROJECT REDUCES RISK; THEREFORE, REDUCING ITS

COST OF CAPITAL.
F.
FINALLY, 21ST CENTURY IS ALSO CONSIDERING PROJECT Z.
PROJECT Z HAS
AN UP-FRONT COST OF $500,000, AND IT IS EXPECTED TO PRODUCE AFTER-TAX

CASH INFLOWS OF $100,000 AT THE END OF EACH OF THE NEXT FIVE YEARS (t
= 1, 2, 3, 4, AND 5).
BECAUSE PROJECT Z HAS A COST OF CAPITAL OF 12
PERCENT, IT CLEARLY HAS A NEGATIVE NPV.
HOWEVER, KELLER AND HIS
GROUP RECOGNIZE THAT IF 21ST CENTURY GOES AHEAD WITH PROJECT Z TODAY,
THERE IS A 10 PERCENT CHANCE THAT THIS WILL LEAD TO SUBSEQUENT
OPPORTUNITIES THAT HAVE A NET PRESENT VALUE AT t = 5 EQUAL TO
$3,000,000.
AT THE SAME TIME, THERE IS A 90 PERCENT CHANCE THAT THE
SUBSEQUENT OPPORTUNITIES WILL HAVE A NEGATIVE NET PRESENT VALUE ($1,000,000) AT t = 5.
ON THE BASIS OF THEIR KNOWLEDGE OF REAL
OPTIONS, KELLER AND HIS GROUP UNDERSTAND THAT THE COMPANY WILL CHOOSE
TO DEVELOP THESE SUBSEQUENT OPPORTUNITIES ONLY IF THEY APPEAR TO BE
PROFITABLE AT t = 5.
GIVEN THIS INFORMATION, SHOULD 21ST CENTURY
INVEST IN PROJECT Z TODAY?

ANSWER:

10%
0k = 12% 1
PROB.
|
|
-500,000 100,000
2
|
100,000
3
|
100,000
90%
|
PROB.-500,000
|
100,000
|
100,000
|
100,000
4
|
100,000
5
|
100,000
3,000,000
3,100,000
|
|
100,000 100,000
-1,000,000
NPV @ t = 0
$1,562,758.19
-139,522.38
WILL NOT DO
IF IT TURNS OUT THAT THE PROJECT AT YEAR 5 HAS A NEGATIVE NPV OF

FUTURE OPPORTUNITIES, THE FIRM WILL NOT PURSUE THEM.
THEREFORE, THE
CASH FLOWS FOR THAT BRANCH OF THE DECISION TREE INCLUDE ONLY THE
$500,000 OUTLAY AND THE $100,000 INFLOWS.
THEREFORE, THE EXPECTED
NPV OF PROJECT Z IS (0.10)($1,562,758.19) + (0.9)(-$139,522.38) =

$30,705.68.
THEREFORE, PROJECT Z HAS A POSITIVE NPV SO THE FIRM
SHOULD INVEST IN IT TODAY.

FFM 9 Im 13

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SOLUTIONS TO END-OF-CHAPTER PROBLEMS

Using a financial calculator, input the following data:

Using a financial calculator, input the following data:

Using a financial calculator, input the following data:

WACC1 = 12%; WACC2 = 12.5%.

Answers and Solutions: 13 - 1

On the basis of a risk-adjusted WACC, Projects B, C, D, E, F, and G will

NPV190-3 = $11,982 (for 3 years).

Answers and Solutions: 13 - 2

Machine As simple NPV is calculated as follows: Enter CF 0 = -10 and

Enter these cash flows into the cash

NPV = $2.4083 million.

Tax not imposed

Answers and Solutions: 13 - 3

a. NPV of abandonment after Year t:

NPV = $4.6795 million.

Answers and Solutions: 13 - 4

NPV = -$19.0099 million.

Answers and Solutions: 13 - 5

The expected NPV of waiting 1 year is 0.5(-$27.1468) + 0.5($45.3430) =

Answers and Solutions: 13 - 7

13-14 The detailed solution for the cyberproblem is available on the

Harcourt, Inc. items and derived items copyright 2000 by

21st Century Educational Products

21ST CENTURY EDUCATIONAL PRODUCTS (21ST CENTURY) IS A RAPIDLY GROWING

WHILE MOST OF THE COMPANYS PROJECTS ARE

FAIRLY EASY TO EVALUATE, A HANDFUL OF PROJECTS INVOLVE MORE COMPLEX

BRINGS THEIR RECOMMENDATIONS DIRECTLY TO THE COMPANYS CFO AND CEO,

RIGHT NOW, KELLERS GROUP IS LOOKING AT A VARIETY OF INTERESTING

FOR EXAMPLE, THE GROUP HAS BEEN ASKED TO CHOOSE BETWEEN

THE FOLLOWING TWO MUTUALLY EXCLUSIVE PROJECTS:

[SHOW S13-1 THROUGH S13-5 HERE.]

USING A FINANCIAL CALCULATOR, INPUT THE FOLLOWING DATA:

USING A FINANCIAL CALCULATOR, INPUT THE FOLLOWING DATA:

IN RECENT MONTHS, KELLERS GROUP HAS BEGUN TO FOCUS ON REAL OPTION

[SHOW S13-6 HERE.]

REAL OPTIONS EXIST WHEN MANAGERS CAN INFLUENCE

THE SIZE AND RISKINESS OF A PROJECTS CASH FLOWS BY TAKING DIFFERENT

2. WHAT ARE SOME EXAMPLES OF PROJECTS WITH EMBEDDED REAL OPTIONS?

[SHOW S13-7 HERE.]

A PROJECT MAY CONTAIN ONE OR MORE DIFFERENT TYPES

OF EMBEDDED REAL OPTIONS.

EXAMPLES INCLUDE ABANDON-MENT/SHUTDOWN

OPTIONS, INVESTMENT TIMING OPTIONS, GROWTH/EXPANSION OPTIONS, AND

TAKING REAL OPTIONS INTO ACCOUNT, ONE OF KELLERS COLLEAGUES, BARBARA

RIGHT NOW, 21ST CENTURY FORECASTS THAT

PROJECT L WILL GENERATE EXPECTED YEARLY NET CASH FLOWS OF $33,500.

THERE IS A 50 PERCENT CHANCE THAT THE MARKET WILL BE

STRONG AND A 50 PERCENT CHANCE IT WILL BE WEAK.

STRONG, THE YEARLY CASH FLOWS WILL BE $43,500.

WEAK, THE YEARLY CASH FLOWS WILL BE ONLY $23,500.

CHOOSES TO WAIT A YEAR, THE INITIAL INVESTMENT WILL REMAIN $100,000.

CENTURY INVEST IN PROJECT L TODAY, OR SHOULD IT WAIT A YEAR BEFORE

[SHOW S13-8 THROUGH S13-11 HERE.]

CONSEQUENTLY, THE EXPECTED NPV OF WAITING ONE YEAR IS

(0.5)$0 + (0.5)($37,889.15) = $18,944.58.

HOWEVER, THIS IS THE

PRESENT VALUE AT YEAR 1, SO MUST DISCOUNT IT BACK ONE YEAR TO FIND

SO, THE VALUE TODAY OF

WAITING IS CALCULATED AS $18,944.58/1.10 = $17,222.34. THEREFORE, THE

$53,500 IF THE MARKET IS STRONG AND $13,500 IF THE MARKET IS WEAK.

WILL THIS INCREASED UNCERTAINTY MAKE

THE FIRM MORE OR LESS WILLING TO INVEST IN THE PROJECT TODAY?